Measurement of National Economy

Lecture 3

Economy’s Income and Expenditure

• When judging how a person is doing economically, we might first look at his/her income.

• Similarly, when judging whether the economy is doing well or poorly, it is natural to look at the total income that everyone in the economy is earning.

• This is the task of “GDP”.

Economy’s Income and Expenditure

Cont…

• GDP measures two things at once:– The total income of everyone in the economy– The total expenditure on the economy’s output of

goods and services.

• The reason that GDP can perform this trick of measuring both total income and total expenditure is that these two things are really the same.

• “Therefore, for an economy as a whole , income must equal expenditure”.

Economy’s Income and Expenditure

Cont…

• Why is this true???– An economy’s income is the same as its

expenditure because every transaction has two parties: A ‘buyer’ and a ‘seller’.

– E.g. A pays B Rs. 500 to clean her lawn. – In this case, B is the seller of a service and A is the

buyer.– B earns Rs. 500 and A spends Rs. 500.– Thus, this transaction contributes equally to the

economy’s income and to it’s expenditure.

• Hence, GDP, whether measured as total income or total expenditure, rises by Rs. 500.

Economy’s Income and ExpenditureCont…

• The equality of income and expenditure can be illustrated with the circular-flow diagram:

Figure 1 The Circular-Flow Diagram

Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of dollars

Factors ofproduction

Wages, rent,and profit

FIRMS•Produce and sellgoods and services

•Hire and use factorsof production

•Buy and consumegoods and services

•Own and sell factorsof production

HOUSEHOLDS

•Households sell•Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

•Firms sell•Households buy

MARKETSFOR

GOODS AND SERVICES

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Measurement of GDP

• In simple terms, Gross Domestic Product (GDP) is a measure of the income and expenditures of an economy.

“It is the total market value of all final goods and services produced within a country in a

given period of time”.

Measurement of GDPCont…

• Break-up of Definition:– “GDP is the Market Value . . .”

Output is valued at market prices.– “. . . Of All Final . . .”

It records only the value of final goods, not intermediate goods.

– “. . . Goods and Services . . .”

It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor visits).

Measurement of GDPCont…

– “. . . Produced . . .”

It includes goods and services currently produced, not transactions involving goods produced in the past.• E.g. When Toyota produces and sells a new car, the

value of the car is included in GDP.

• But when a person sells a used car to another person, the value of the used car is NOT included in the GDP.

– “ . . . Within a Country . . .”

It measures the value of production within the geographic confines of a country.

Measurement of GDPCont…

– “. . . In a Given Period of Time.”

It measures the value of production that takes place within a specific interval of time, usually a year.

Components of GDP

• GDP includes all items produced in the economy and sold legally in markets.

• GDP excludes items that never enter the marketplace.

• It excludes items produced and sold illicitly, such as illegal drugs.

Components of GDPCont…

• GDP is divided into four components:1. Consumption (C)2. Investment (I)3. Government Purchases (G)4. Net Exports (NX)

• GDP (Y) is the sum of these and is calculated as per the following equation:

Y = C + I + G + NX

Components of GDPCont…

• Consumption (C):– The spending by households on goods

and services.• Investment (I):

– The purchase of goods and services to be used in future.

– The spending on capital equipment, inventories, and structures etc.

Components of GDPCont…

• Government Purchases (G):– The spending on goods and services by

local, state, and federal governments.

• Net Exports (NX):– Is the difference between the monetary

value of exports and imports.– In simple terms, it refers to exports minus

imports.

GDP and Economic Well-Being

• GDP is the measure of the economic well-being of a society.

• GDP tells us the income and expenditure of the people in the economy.

• Higher GDP indicates a higher standard of living.

• However, GDP is not a perfect measure of the happiness or quality of life.

GDP and Economic Well-Being

Cont…

• Following factors contribute to well-being but are not included in GDP.– The value of leisure.– The value of a clean environment.– The value of certain activities such as the

value of the time parents spend with their children and the value of volunteer work etc.